A Dynasty Trust is a long-term trust created for the purposes of passing and building wealth from generation to generation without incurring federal estate tax. For families with significant wealth, this trust provides substantial tax savings for future generations for up to 360 years in Tennessee.
How Does a Dynasty Trust Work?
The Dynasty Trust can created in your will or revocable living trust or it could be created and funded during your life. The idea behind the this type of instrument is that your children do not receive their inheritance outright. Instead, your assets pass through the dynasty trust and stay in the dynasty trust for their lifetime. Most often, clients want their children to be trustees of their own trust and that is certainly possible. But the dynasty trust must have certain boundaries/standards by which money may be used. The broadest limits we usually put in the dynasty trust are the assets may be used for the child’s health, education, maintenance, and support. That restrictive language is critical to ensure that the assets in the trust are not included in the child’s estate. A trust with no standard by which the trustee must distribute assets would likely cause the trust to be included in their estate. This circumstance would make the assets subject to the estate tax and thereby defeat the entire purpose of the Dynasty Trust.
Be aware that if you use a broad standard for distribution of the assets, it would ensure that the child may use significant portions of the assets for their needs. For example, if your child wanted to purchase a home she could do so with trust assets. If she needs groceries, or to pay for medical expenses, the money would be there to support her.
Limited Power of Appointment
Also, included in the Dynasty Trust is a limited power of appointment. This limited power of appointment allows the trustee to appoint trust property by will to whomever they like. So, if Nicole wanted to leave her trust assets to her spouse or children she can choose to do so in her will. But note, the Dynasty Trust has a provision which directs the trust assets to pass to your lineal decedents should your children fail to exercise this power of appointment.
Even if your children do not exercise their limited power of appointment, the trust assets will be provided to the new beneficiaries in a new Dynasty Trust that will be governed by terms and standard of the original Dynasty Trust. As such, each successive generation of beneficiaries will have a power to appoint where these assets go in their will, just as if they owed the assets personally. But these successive beneficiaries will never own the assets personally. Rather, the trustees will control the assets in trust and keep them free from estate taxation for generations to come.
Power to Appoint Trustees
Under the terms of the Dynasty Trust, your daughters would have the ability to appoint new trustees at their death. For example, your children could easily name your grandchildren as trustees of their trust once they are of age. On the other hand, if a grandchild has substance abuse problems, your child may decide to name a third party as trustee for that grandchild for his or her life.
Protection from Creditors
An understated benefit of a Dynasty Trust is assets placed into the trust are protected from the claims of creditors. This means that in the event any of your descendants incur any debts on their own, their creditors will never be able to seek relief from the assets in this trust. Additionally, the Dynasty Trust is a good estate planning vehicle for ensuring that the wealth your family has stays within your family bloodline. By placing your assets into a Dynasty Trust, you can ensure that the wealth will be protected from any future ex-spouses in the event of divorces.
Drawbacks to Dynasty Trusts
While there are many benefits to including a Dynasty Trust within your estate plan, there are two significant drawbacks to using a dynasty trust.
The trust, like most irrevocable trusts, will be subject to an income tax that has a higher tax rate than that of an individual tax payer if the income of the trust is not distributed directly to the beneficiary. Currently, the highest income tax rate on a trust is 40%. This rate is higher that any personal tax rate. But if the income of the trust is distributed to the beneficiary, the beneficiary pays the tax at his or her personal tax rate. (Note this is income tax and not the estate tax. If the trust is properly planned the principal of the trust will not be taxed, only the income derived from the assets in trust). Accordingly, if your children want to live off of the income of their trusts they can do so. The income from the trust would only be taxed at their personal tax rate, not at the rate of 40%. It is only taxed at a maximum rate of 40% if the funds are reinvested in the trust.
No Step-Up in Basis
Second, it is likely that assets that were purchased many years ago have increased in value over time. If the assets are owned by individuals they will receive a step-up in tax basis at the death of the owner. What that means is if the owner dies his family inherits the property based upon the value at his death, not what he paid for it. This step-up in basis amounts to significant tax savings for families. However, that is not the case with dynasty trusts. These trusts do not provide families with a step-up in basis at the death of each successive generation. So, as a consequence, a dynasty trust may not be appropriate for families that plan to sell assets down the road.